Markets have gotten much more volatile this year. Here’s why this shouldn’t worry long-term investors.
For investors who only recently started participating in the stock market, 2018 has been a trying year. While returns on U.S. stocks are still somewhat positive from the start of the year, October saw some dramatic selloffs, which followed the strong rebound off of weakness earlier this year, and market turbulence has extended into November.
Is this volatility a problem? In short, no.
Volatility fluctuates based on where we are in the business cycle, but it is a normal feature of markets that investors should expect.
Right now, we are in the later stages of nearly a decade of expansion that followed the financial crisis of 2008. After that tumultuous period subsided following the de-escalation of the European crisis, markets enjoyed years of calm brought about by a gradually improving global economy, low interest rates and global central banks that aggressively pursued unconventional monetary policies, like quantitative easing.
That started to change recently as global economic growth picked up speed in 2017, raising concerns about inflation and what that could mean for the future path of monetary policy. While a small amount of inflation is good for markets, too much can prompt central banks like the Federal Reserve to put the brakes on economic growth through higher interest rates, which negatively affects financial conditions and corporate profitability. So far, the uptick in volatility seems attributable to this increase in uncertainty as well as the market working out some of the complacency that had begun to take hold among investors.
I’m still positive on the prospect that the market will produce positive returns in the short-term. At some point along the way, however, it’s likely that the market’s headline-grabbing down days won’t be followed by rallies, and the market will head lower in ways that leave investors with losses. That is the typical way the market responds to economic recessions, events that are a feature of market economies as inevitable as the turning of the seasons.
Does that mean you should sell now? Not necessarily. The next recession could be months or even years away. It’s extremely difficult to predict the timing with the accuracy needed to profit from such a prediction.
More to the point, it is easy to get such a prediction wrong, which can be costly. While we do tilt our portfolios more aggressively or more conservatively based on our market outlook, individual investors who radically reposition out of stocks in an attempt to catch the tip of a market top reliably miss out on gains more than they prevent losses, and generate excessive transaction and tax costs along the way.
While “buy low, sell high” may sound like time-honored advice, it rarely is a good way to make decisions in practice. Indeed, individual investors who stay in cash waiting for a bear market to come and go, often lose patience as stocks continue to go up. This results in their missing out on gains rather than preventing losses. That costly mistake is the reciprocal of another, wherein panicking investors sell during a major market selloff, and remain on the sidelines too long as stocks rebound, effectively locking in their losses. The prevalence of these value destroying behaviors helps to explain why individual investors as a group tend to dramatically underperform market benchmarks.
There is a caveat to the generally superior buy-and-hold approach, which is that seeing a paper loss in your portfolio doesn’t feel good. Some investors would rather take less risk, which may mean giving up some long-term returns, in order to reduce the period of time they may need to wait out losses, making for smoother sailing.
Another caveat to the buy-and-hold idea comes when investors take a goals-oriented approach. If you are saving towards a goal and have made good progress, it may make sense to take on less risk, regardless of the market outlook. This is for two reasons. First, it intuitively makes less sense to take risk when you have more to lose than to gain regarding the goals you care about. Second, for additional peace of mind that your progress won’t be jeopardized, you may desire the lesser uncertainty that can come from a more conservative blend of stocks, bonds and cash.
If, like many of us, you have more progress to make and more road to travel towards achieving your goals, riding out the market’s jitters can be the best advice. Our research shows that markets are most predictable when you have a seven- to 10-year time horizon (due to how well current yields and valuations predict returns over those horizons). Our forecasts continue to suggest that stocks will outperform bonds and cash over that time horizon.
Bottom line: Investing is a long-term proposition and having a long-term horizon is your best strategy as an investor.